TCS Daily

Behind the Fed's Policy Leak

A front-page WSJ story, "Fed Mulls Symbolic Shift," is a great leak from
the central bank to reporter Jon Hilsenrath. Basically, the Fed wants
to stop its $2.3 trillion balance-sheet portfolio from shrinking and
therefore tightening monetary policy. So, when its mortgage-bond
holdings mature, the Fed would take the principal and interest and go
into the open market to replace the bonds. This would keep the Fed's
holdings flat, or stable, rather than have the holdings run off.

Inflation-sensitive
markets did very little on the news yesterday. Gold was up slightly to
$1,189, and the trade-weighted dollar continued its recent drop by about
half a percent to 80.6.

What's really behind the Fed move -- if
the central bank announces it at its mid-month FOMC meeting -- is fear
of an economic slowdown. The Fed doesn't want to be seen as tightening
its policy. The target rate is near zero already. But the balance sheet
is the key to money creation.

Noteworthy is the fact that the
monetary base has been flat-lined at $2 trillion for about 10 months,
going back to last October. In sound-money terms, it would be okay with
me if the Fed held the monetary base steady for a long, long time. That
would keep the dollar stable and would probably keep gold prices steady.
If investors actually believed in a stable policy, perhaps the
greenback would rise while gold fell.

But alas, Bernanke is
still engaged in economic fine-tuning rather than dollar value. We have
no exchange-rate policy. Nor is there a gold policy. So no one could
possible know where these prices are going.

Thinking back to
Robert Mundell's original idea years ago, an optimal policy would
include low marginal tax rates and a steady dollar backed by gold. But
marginal tax rates may go up, the dollar is not backed by gold, and the
fate of the greenback is anyone's guess.

Meanwhile, buying more
bonds to create new cash for the economy is futile. There's already $1
trillion of excess bank reserves on deposit at the Fed. In other words,
the financial system has more dollars than it knows what to do with.

The
economic recovery and job creation are being held back by tax and
regulatory obstacles, not by a shortage of money. It's fiscal policy
that is wrongheaded. But then again, without a strong-dollar policy, no
one can really give the Fed any kudus either.